Frontier Advisors, LLC

Happy 2010 everyone,

I know I’ve been silent for a while – I just thought I would respect everyone’s holiday period and allow you to get your new year comfortably started before bombarding you with things to think about regarding investing.  As a first effort in this new year, I’d like to draw your attention to an opinion piece by John Bogle in today’s Wall Street Journal.  For copyright reasons I can’t send around copies, but I’m happy to provide the link to the site for you to read there (it’s in the non-subscription part, so all can read for free): Bogle article in WSJ

The reason I’ve chosen this piece is that Mr. Bogle makes several points I think are worth thinking about:
– “the folly of short-term speculation has replaced the wisdom of long-term investing”
– “the financial sector became the driving force of the US economy…mutual fund fees and expenses rose to $100 billion from $47 billion…[and] the higher these intermediation costs…the lower the returns to investors as a group”, and ” the investor feeds at the bottom of the food chain”
– quoting former Fed Chairman Paul Volcker, “the only financial innovation of the era that added value was the ATM” (and he later agreed about adding the index fund to that comment)
– ‘What we need is congressional action to establish a federal principal of fiduciary duty – encapsulated by the phrase, “no man can serve two masters”‘

He also does a great job on other points, but those I’ve just mentioned are the most relevant to my own soapbox.  So, to address the above points in my own way, John Bogle is exactly correct that speculation has overtaken investing and, in my own way of putting it, the markets have turned into a system of legalized gambling.  That’s perfectly fine for those who actually intend to gamble with their assets, but my concern is that most of the assets in the capital markets are there for investment purposes but have been commandeered by investment managers, institutional or otherwise, who cannot separate the ideas of speculating and investing.  Those managers delude themselves into thinking that the work they do actually adds value and is not just a sublime form of speculation.

These managers and their speculation have helped fuel the growth of the financial sector and now “the house” gets compensated incredibly well by the unknowing investors who likely have no idea how much they actually pay for investment management nor how to assess whether those management services are worth the cost.  The truth of the matter is that very little of the fee goes toward anything the investor would actually be comfortable with paying for: marketing costs, sales forces, lobbyists to fight industry regulation, fantastic office space, bonuses that don’t reflect effort, research teams that can’t improve investment decisions, SEC fines, etc.  And after those fees have been extracted from investment returns, performance for most actually stands below what the relevant benchmark index returned.  Investors truly are at the bottom of the very food chain that should exist for their benefit!

And after all that the financial sector has created over the last few decades, very little of it actually does any good.  Most of it is expensive smoke and mirrors that, when you look at it objectively, is just a wrapper around what we could already be done via an investment in stocks or bonds.  Volcker mentioned the ATM and the index fund as the only two worthwhile advances, but I would add the exchange traded fund.  Some of you may have heard me say that the ETF is the far and away greatest innovation for investors in the last twenty years and I maintain that.  No other innovation that I know of has done more to benefit the investor than the ETF, but I also add that even this innovation has been twisted by “the house”, so investors need to be very careful and not treat all ETFs as sound investments.

Finally, I am no fan of government regulation any more than other ardent capitalists, but the financial industry has become something that could use a solid and distinct kick in the pants so that the average investor gains significant protections.  A fiduciary standard for all who are stewards of others’ assets would be a great step in that direction.  Surprisingly enough, no broker today (or financial advisor, as those employed by the Bank of America Merrill Lynches and Morgan Stanley Smith Barneys would call themselves) is held to a fiduciary standard.  Nor will they be anytime soon, in my opinion – the industry has too much clout in Washington, and a fiduciary standard would completely undermine the current system for distribution of investment products to unwitting investors.  Conflicts of interest are far too entrenched in that part of the business and a fiduciary standard, while completely necessary, will simply not happen.  Of course, investors have the Registered Investment Advisory community at their disposal and can avoid the brokerage industry altogether, but few seem to understand this subtle but very important distinction (full-disclosure, Frontier Advisors is a Registered Investment Advisory).

Today I was reminded of a research paper by a couple of my favorite academics that helps validate the intellectual foundation of our investment philosophy at Frontier.  The study is called “Luck versus Skill in the Cross Section of Mutual Fund Returns” and is a working paper by two giants in the area of market efficiency, Eugene Fama (University of Chicago) and Kenneth French (Dartmouth).  They look at mutual fund performance since 1983 (when monthly returns began being recorded consistently), after costs and after controlling for a variety of data biases, and compare the actively managed funds to the broad market to see if there is any excess return among the actively managed funds that was strong enough and persistent enough to be the result of actual skill on the part of the manager(s).  Active management, for those unfamiliar with the term, is when portfolio managers pick stocks they expect to outperform a broader market.  Conversely, passive management is when you simply buy the entire market and accept the returns it yields.

They conclude in the study that there is evidence that skilled active managers exist, but only in the top three percent of the actively managed fund universe!  That, of course, means that there are a lot of fund managers out there who are patting themselves on the back for their “market beating” performance when they deserve no credit whatsoever.  In fact, they could actually be lousy portfolio managers who simply got lucky, just as many underperforming managers could actually be good but unlucky.  The bottom line is that picking active managers becomes nothing more than a guessing game that one is more likely to lose than win after costs are factored in.

And, these conclusions offer us a new way to look at studies like the semiannual Standard & Poor’s Indices vs. Active (SPIVA) Funds Scorecard.  While the SPIVA study does tend to show that a majority of active managers underperform their passive benchmarks over 1, 3, and 5 year periods, it also indicates that many active managers do outperform their index, even if a minority.  While that may be the case during a given period, the Fama/French paper tells us that it is very likely that most of those outperforming funds were just plain lucky, giving an investor little confidence that an outperforming manager will repeat in the next period.

These kinds of conclusions become very disturbing when you consider what one pays active managers and those selecting active managers on their behalf.  Actively managed U.S. equity funds charge, on average, 1.32%, and those investment advisors who build portfolios from actively managed funds often charge another 1% on top of that for their “efforts”.  Pay 2.32% of assets just so your performance can depend on luck?!  A much more rational approach, in our opinion, is to remove the luck component from this all-too-important endeavor and build portfolios with indexed vehicles using what we know about the various investable markets and their relationships to each other.  That way, investors can get extremely efficient exposure to the markets at the level of risk appropriate for them, and at a much more agreeable cost since you aren’t paying for “luck” (some passive strategies cost as little as 0.07%), let alone all the other stuff that fees go toward at most firms.  This approach is no walk in the park, of course, requiring time, effort, and a good dose of knowledge and perspective.  But it yields a much more satisfying investment experience, we believe.

For those interested I’ve attached the Fama/French paper, Luck vs. Skill in Mutual Fund Investing, and the most recent SPIVA report to this email.  Keep in mind, Fama/French paper is over 40 pages and very academic, but some of you may need help getting to sleep some night.  The paper is also available in the Research section of our website in case anyone wants to find it again later.